Differential reporting aids SMEs
Media release on differential reporting
FRSB approved the Framework for Differential Reporting in May 2005; in June 2005, approved by ASRB
IASB is developing IASB standards for SME ; NZ framework is interim measure – a short-term conversion of existing measures
What are differential reporting standards
What does this mean for the entities affected
“The Framework for Differential Reporting permits certain entities to adopt less comprehensive disclosure, while remaining IFRS compliant, through a regime of partial and full exemptions from Financial Reporting Standards. An entity will qualify for differential exemptions if the entity does not have "public accountability"16 and:
- at balance date, all of its owners are members of the entity's governing body; or
- the entity is not large (i.e. does not exceed any two of the following three size thresholds: total revenue of $5.0 million, total assets of $2.5 million, 20 employees).
16 An entity has "public accountability", for the purposes of the Framework, if it:
- is or was an issuer (as defined in the FRA) in the current or preceding accounting period; or
- has the coercive power to tax, rate or levy to obtain public funds. “ From MED site
In New Zealand
In response to an urgent need for differential reporting concessions which acknowledge the different cost benefit considerations associated with financial reporting for qualifying entities.
Who is FRSB: Financial Reporting Standards Board
IASB International Accounting Standards Board
IFRS International Financial Reporting Standards
ASRB Accounting Standards Review Board
SMEs Small to Medium-sized Enterprises (check definition in MED site)
From the Interim Report of the Ministerial Inquiry into compliance costs.
“Differential reporting recognises that the benefits and costs of financial reporting differ between reporting entities. It allows entities, in certain circumstances, to differ by way of exemptions, in the financial reporting disclosures made, and the accounting practices adopted, from those required by certain FRS and GAAP.
The exempt company regime takes precedence over differential reporting. A company which falls within the exempt company criteria under the FRA must comply with the specific requirements contained within the FRO. As a result, such companies do not fall within the scope of the differential reporting regime. Differential reporting can only be applied to companies not within the exempt company criteria, and which meet the criteria for differential reporting within the FRS.
An entity qualifies for differential reporting when the entity does not have public accountability, and:
- all of its owners are members of the entity's governing body; or
- the entity is not large.
An entity is large if it has any two of the following:
- total revenue of $5 million or more;
- total assets of $2.5 million or more; and
- 20 employees or more.
The primary difference between the application of the exempt company regime and the differential reporting criteria is the treatment of closely held companies. Where every owner of an entity is also a member of the entity's governing body then there is no accountability requirement between the governing body and the owner requiring that the applicable FRS be complied with in full. The differential reporting regime is more sensitive to the primary recipient of the financial information. There is no such consideration within the exempt company regime.
The differential reporting regime also has a broader application than the exempt company regime. The differential reporting regime has a higher monetary threshold, therefore applying to a larger number of entities. However, the public accountability restriction largely equates with the prohibition of "issuers", as defined in the FRA, from the exempt company regime.
We were advised that accounting practitioners, consulted by the Ministry of Commerce, indicated that there is often more time required, and little cost reduction, to produce a set of financial reports under the exempt company regime, as opposed to the differential reporting regime. This is likely to be due to the high level of automation in preparing financial statements on computer software designed in accordance with FRS.
The FRO sets out a pro forma simplified balance sheet and profit-and-loss statement to cover all entities, but the range of companies is too great to be captured in the prescribed basis. For example, the FRO requires exempt companies to value inventories at the lower of cost and net realisable value. This treatment is appropriate for those exempt companies that buy in their inventory, such as retailers, but inappropriate for those exempt companies that grow their inventory, such as farmers. For the latter, the cost is likely to be zero which is clearly not an accurate valuation of livestock.
It was suggested that the very simplicity of the FRO has led to confusion and ambiguity due to its silence on key accounting requirements, such as the format for the measurement of liabilities. We were also informed of technical differences in the accounting policies employed in the differential reporting regime and the exempt company regime, such as the treatment of inventory.
The FRO is seen by some practitioners to reduce the usefulness of the financial statements themselves. The FRO is heavily prescriptive, in terms of format. There is no option for exempt companies to produce their statement in any other form, even if another form might give a better representation or allow easier interpretation of the statements.
There is no process in place to amend the FRO over time, as exists for financial reporting standards through the ASRB. Yet without amendment, the FRO will become out of date, reducing the value of reports produced under the regime.”
From KPMG comment on discussion doc
- The Framework is largely based on the Framework for Differential Reporting developed in 1994 and revised in 1997 and 2002.
- The FRSB does not propose to change the approach used in assessing whether an entity qualifies for differential reporting concessions, but it does propose to increase the size criteria of both the old and new Frameworks. The new size criteria will be consistent with that proposed in the MED Discussion document Review of Financial Reporting Act 1993 Part II. Therefore an entity will be considered 'large' if it exceeds any two of the following:
(a) total income of $20 million (previously $5 million)
(b) total assets of $10 million (previously $2.5 million)
(c) 50 employees (previously 20)
- Appendix 1 to the Framework details the exemptions and disclosure concessions available to qualifying entities. Appendix 1 to this Flash Report summarises the level of exemption for each standard, i.e. full exemption, partial exemption or full compliance.
Key proposals impacting qualifying entities under the new Framework
The proposed Framework is an interim measure
This Framework represents an interim approach to the development of differential reporting concessions for entities under NZ IFRSs. It is based on the Framework for Differential Reporting initially developed in 1994. Two current developments could impact the proposals set out in the Framework as proposed in ED-98 or lead to reviews of the Framework in the short term:
- The International Accounting Standards Board (IASB's) project on reporting requirements for small and medium entities (SMEs); and
- The Government's review of the Financial Reporting Act 1993.
Asserting compliance with IFRS
Qualifying entities electing to apply differential reporting concessions in producing financial statements will not be able to assert compliance with International Financial Reporting Standards, but will be able to assert compliance with NZ GAAP. This is because such entities will not have met all the requirements of IFRSs.
Proposals in relation to specific Standards
Although ED-98 is largely based on the current Framework for Differential Reporting, there are some differences to current requirements (and expectations) that should be highlighted:
NZ IAS 7 Cash Flow Statements (full compliance)
The FRSB considers that financial statements have become more complex and in some cases involve a high level of judgement. However, the cash flow statement has remained relatively easy to understand and involves a low level of judgement. It also provides a useful tool for analysing comparatives and contains important information that is not necessarily readily assessable from the other statements. Currently qualifying entities are exempt from preparing a cash flow statement.
NZ IAS 24 Related Party Disclosures (partial exemption)
The FRSB has proposed that the only exemption would be in respect of disclosure of key management personnel compensation. This will lead to an increase in the level of related party disclosures in financial statements of qualifying entities. This is to ensure that users of the financial statements receive adequate information on an entity's related party relationships and transactions, particularly given the potential impact of related party transactions on the reported financial performance and position of an entity. This proposal is consistent with the proposals in ED-91 Related Party Disclosures, which, in turn, were influenced by feedback from constituents in relation to ED-74 Related Party Disclosures issued in May 1994. Current related party disclosure requirements for qualifying entities are very limited.
NZ IAS 12 Income Taxes (partial exemption)
It is proposed that qualifying entities are allowed to account for income taxes either in accordance with NZ IAS 12 or using the taxes payable method. Further concessions from disclosure requirements are provided to entities using the taxes payable method, insofar as they relate to disclosure of deferred tax expense (income). The proposals are consistent with current concessions.
NZ IAS 41 Agriculture (partial exemption)
The concessions allow qualifying entities to use either fair value (in accordance with paragraphs 12 and 13 as applicable), or cost models to measure each class of biological asset and agricultural produce. This concession applies even when the fair value is reliably measurable. It is important to note that some sectors currently use essentially a cash basis, which will not be permitted. In addition some disclosure concessions are also available.
NZ IAS 32 Financial Instruments - Presentation and Disclosure (partial exemption), NZ IAS 39 Financial Instruments - Recognition and Measurement, and NZ IFRS 2 - Share Based Payments (full compliance)
Although qualifying entities may have expected some concessions, the FRSB has proposed full compliance with NZ IAS 39 and NZ IFRS 2 and partial exemption from certain disclosures in NZ IAS 32. Qualifying entities were previously fully exempted from FRS-31: Financial Instruments: Presentation and Disclosure.
ED-98 outlines both the proposed concessions and the rationale for these concessions (shown as boxed text). The explanatory notes accompanying concessions do not form part of the proposed Framework. They are provided for information only and will not be reproduced in the final pronouncement.
- More entities may qualify for differential reporting concessions based on the revised size criteria.
- The proposed withdrawal of the existing concessions in relation to cash flow statements and related party disclosures will lead to increased costs for some entities.
- Qualifying entities electing to apply differential reporting concessions will not meet all the requirements of IFRSs and therefore they will be unable to assert compliance with IFRSs.
Model financial report
We will soon be releasing a revised version of our model financial report 'ClearCut Limited', prepared under the proposed differential reporting regime. This model financial report provides a practical illustration of the concessions available to qualifying entities.
A copy of ED 98 is available from the ICANZ website at: http://www.icanz.co.nz. The due date for submissions is 25 February 2005.
Application of Differential Reporting Proposals to Specific Pronouncements.
What Is an "Exempt Company"?
5. The ECR is contained in the FRA and prescribes the financial reporting obligations for most SME companies. Under the FRA all companies are either "reporting entities" or "exempt companies".1 Exempt companies are exempted from the full financial reporting requirements that apply to reporting entities. In particular, exempt companies must prepare financial reports in accordance with regulations, whereas reporting entities must prepare financial reports in accordance with Generally Accepted Accounting Practice.
6. An "exempt company"2 is generally a company, other than an "overseas company"3 or an "issuer",4 that:
- has no more than $450,000 in assets;
- has no more than $1,000,000 per annum in turnover; and
- does not form part of a group of companies.
Characteristics of SME Companies in New Zealand
7. SMEs make an important contribution to the New Zealand economy in terms of job creation, innovation (that is the development and diffusion of new technologies) and maintaining the efficiency of markets.5 There are approximately 260,000 enterprises in New Zealand and as many as 220,000 of these will be micro businesses employing five or fewer staff.6
8. A significant proportion of the 220,000 micro businesses referred to above will be structured as companies7 and fall within the FRA definition of an "exempt company". It is reasonable to assume that most companies in New Zealand will be exempt companies, and can loosely be described as "SME companies".
Distinctive Characteristics of SME Companies
9. Although there is little empirical literature on the qualitative profile of New Zealand's SME companies, international research suggests8 that SME companies have a number of distinctive characteristics compared to larger companies. For example the majority of SME companies will:
- be managed by their owners and are therefore unlikely to have the degree of public accountability to shareholders that is characteristic in larger companies. This means that their financial reports will only be of interest to a small group of users;
- have limited internal resources and can least afford outside expertise or achieve economies of scale;
- have a high proportion of trade debt in their asset structure;
- be more reliant on short-term loans and overdrafts;
- be less reliant on shareholders' interests to finance their assets;
- have higher gearing ratios; and
- have trade and other creditors constituting a higher proportion of their total liabilities.